EXPLAINER: What Is The Freemium Business Model?

Plenty of startups out there want to do go for a "freemium" business model, but there's a lot of confusion as to what "freemium" actually means. And more importantly, whether and how it works. So here's a primer.

What Freemium Is (And Is Not)

Freemium means the vast majority of your users use your product for free and a minority pay.

Importantly, this means that freemium is NOT the same thing as "premium with a free sample." Plenty of software as a service (SaaS) companies have some sort of free option, but the goal is to have the majority of users pay. A restaurant that offers free appetizers is not a freemium business, and neither is 37signals.

Why You Would Go Freemium

There are basically two reasons to go for a freemium business model:

Marketing. By definition, having a free product makes it really easy to get customers. And internet economics make this very attractive, because the marginal cost of every new free users will be very low. Free users can also be good marketing because even though a free user might not convert, they can invite other free users who might.

Network effects. A network effect is what happens when a product or service becomes more valuable the more people use it. A phone isn't very useful if you can't call anyone else with it. But once everyone you know has a phone, it becomes a pretty valuable thing to have. If you're in a market that lends itself to network effects you're going to want to have a free basic product because if you don't someone else will and will use the network effects to crush you.

What Freemium Needs To Work

This is the part where there's the most confusion. Not every product or service can work as freemium.

Plenty of startups like the idea of a freemium model, because they can have a free product and get lots of users really fast, but at the same time tell themselves they have a business model and can eventually make money.

One of the best experts on freemium business models is Evernote Founder/CEO Phil Libin, whose freemium company is very profitable and who has given several talks on how and why the freemium business model works for him. According to Phil Libin, here's what you need to be able to do to make freemium work:

Get lots and lots of free users. It seems obvious, but it's important to keep in mind. Freemium is a numbers game: if only 1% of your users are going to pay you, then you need to have lots and lots of free users (millions, typically) to make that 1% enough money.

Get all of these users to stick around. Also important, as we'll see.

HAVE A PRODUCT OR SERVICE WHOSE VALUE TO USERS INCREASES WITH TIME. This is the biggest thing that most people miss, hence the caps. The value of your service needs to increase the more people use it. A classic example is Spotify, where you create all your playlists and organize your music. Once you've done that, as investor Sean Parker says, "we've got you by the balls," and you're much more likely to pay up. The value of Spotify to you has gone up from being just music to music, your playlists and your friends' playlists, so paying starts to make sense.

Keep costs low. Also seemingly obvious but actually a big deal: freemium works because the marginal cost of each additional user is low, so you need to keep your operating costs correspondingly low. Again, internet economics, through things like open source and the cloud, help, but that's not going to be true for everyone.

The Drawbacks Of Freemium

Freemium can sound like the perfect business model: the benefits of free users and the benefits of paying users. And sometimes it is. But not always. The main drawbacks are basically a function of the plusses seen above:

You need lots and lots of users. Freemium will only work if your idea has the potential to reach millions of active users. If it's more niche, you should go the premium route.

You need lots and lots of returning users.Freemium works if your users stick around and start to love the product. If you can attract tons of users but they're less sticky (if you have great search engine rankings for example), you might be better off monetizing through advertising.

It takes a long time to be profitable.Because users take longer to convert as the value of the product to them increases over time, and because you keep adding (hopefully) new free users, freemium businesses take a long time to reach breakeven point. Once they do they can be very profitable, because your revenue per active user grows faster than your cost per active user, but it takes a while to reach breakeven. Equity financing (angels and VCs) or alternative sources of revenue can help you bridge the gap but not everyone has that opportunity or wants to do that.

Freemium can work for plenty of businesses and not others, so we've put together a list of startups that did (or didn't) succeed with freemium, and why.